The exploration and production (E&P) sector is really heating up in the US, and there are some great bargains at this point in the cycle, writes Elliott Gue of The Energy Strategist.

Closely monitoring the schedule of master limited partnerships and US oil and gas royalty trusts slated for initial public offerings can pay off handsomely for income-seeking investors.

Financial Web sites routinely miscalculate the yields offered by these securities until the fledgling stock has paid a full year of distributions. This oversight means that these high-yielding gems often don’t appear on investors’ radar screens for at least six months after going public.

Few investors bother to read the lengthy S-1 registration statements that sponsors file with the Securities and Exchange Commission prior to the IPO. These documents outline the MLP or royalty trust’s asset base, their exposure to commodity prices, and management’s assessment of how quickly the distribution will grow during the first few years as a publicly traded entity.

If you take the time to cull through these statements and identify the likely winners, you can get in before the herd notices the trust’s rapidly growing quarterly payout and piles into the stock.

SandRidge Mississippian Trust II (SDR) filed its first S-1 registration statement with the SEC on January 5. Although this initial filing often lacks certain details, the document often contains enough information for you to ascertain whether the proposed IPO warrants further monitoring.

This first glimpse into the structure and growth potential of SandRidge Mississippian Trust II, a spin-off of independent producer SandRidge Energy (SD), suggests that the latest offering could be a winner—provided that the price is right.

SandRidge Energy’s first royalty trust, SandRidge Mississippian Trust I (SDT), amended its S-1 form six times during the three months that transpired between the initial filing and the security’s first day of trading. Based on this precedent, SandRidge Mississippian Trust II’s IPO would likely occur in April.

SandRidge Mississippian Trust II represents a royalty interest in a series of existing and planned oil and gas wells in northern Oklahoma and southern Kansas. The 81,200 gross acres covered by the royalty interest, or area of mutual interest (AMI), are located in the Anadarko Basin, a mature oil- and gas-producing region where SandRidge Energy has amassed 1.5 million net acres.

These royalties entitle unitholders to 80% of the proceeds from 67 existing wells within the AMI and 70% of the proceeds generated by 206 developmental wells that SandRidge Energy will drill before the end of 2015. These wells will target the Mississippian formation, an oil-bearing deposit that’s been in production since the 1940s.

Decades’ worth of geologic data and production records dramatically reduce drilling risk in the region. Much like the Permian Basin of south Texas, portions of the Anadarko Basin have recently enjoyed a renaissance, thanks to hydraulic fracturing and horizontal drilling.

Directional drilling enables producers to target a field’s most productive portions by carving out a well that branches off horizontally from the vertical shaft. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks.

Producers have drilled about 400 horizontal wells targeting the Anadarko’s Mississippian formation since 2007. With 19 horizontal drilling rigs, SandRidge Energy is one of the play’s most active operators.

Although crude oil accounts for slightly more than half the output from the AMI, elevated oil prices and depressed natural gas prices should ensure that more than three-quarters of the trust’s total revenue will come from oil sales.

SandRidge Mississippian Trust II won’t be responsible for the costs associated with drilling the 206 developmental wells outlined in the S-1 registration statement, though the trust will pay its share of post-production expenses. Investors will receive virtually all revenue net of expenses in a quarterly distribution.

The trust will disburse these payouts about 60 days after the end of each quarter. Unitholders will likely receive their distributions at the end of February, May, August, and November.

The trust officially launched on January 1, and will disburse its first payout (covering royalties from January and February) on May 30. Future distributions will cover three-month periods. Investors should note that the quarterly payouts will vary based on prevailing commodity prices, though SandRidge Mississippian Trust II will include two features that mitigate the effect any fluctuation in oil and gas prices have on the trust’s cash flow.

First, SandRidge Energy will hedge a portion of the trust’s oil and gas output. Amendments to the trust’s initial S-1 filing should outline the extent to which these hedges will cover estimated production, the commodity prices locked in by these hedges, and when these contracts will expire.

And SandRidge Mississippian Trust II’s targeted distributions reflect oil prices that average $102.50 per barrel in 2012, $99 per barrel in 2013, and $95 per barrel in 2014. This forecast calls for oil to trade for less than $120 per barrel throughout the next 20 years—an extraordinarily cautious outlook. I expect oil to eclipse $120 per barrel with increasing frequency in coming years.

Two, the short distribution history of SandRidge Mississippian Trust I suggests that SandRidge Mississippian Trust II’s targeted distributions will prove somewhat conservative.

Based on the current distribution estimates and the yields of other, similar trusts, I would regard SandRidge Mississippian Trust II as a buy under $24 per unit and a steal at less than $20.50 per unit.

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